The reports indicate Microsoft wants to revitalize its lagging mobile business by taking on the big guns, the iPhone and Google's Android phone, which recently shifted 1m units in the US.
Microsoft's smartphone is said to incorporate its Zune mp3 player and Window's Mobile software, with hardware made by a third party manufacturer, likely Taiwanese company HTC.
The new Microsoft phone is also said to integrate Windows Marketplace, similar to Apple's App Store from which users can download various applications for phones for a small fee.
It will also incorporate software from Microsoft's newly acquired software firm Danger, which specialises in mobile devices.
Microsoft played down the rumours in a statement, saying "Microsoft is not going into the phone hardware business" and "Microsoft is not building a Zune-specific phone".
However, those watching the industry see the statement as a Microsoft distraction tactic, aimed at not discouraging consumers from purchasing Windows Mobile products while waiting for a Microsoft smartphone instead. The company could still release a smartphone, made by a third party manufacturer, with Zune capability without breaching any of the claims in the statement.
Two years ago, Microsoft denied rumours that it was creating an mp3 player to compete with Apple's iPhone, eventually releasing the Zune three months later.
Temporarily named 'Pink', the new product -- as first reported in the Wall Street Journal -- follows a slew of other rumours that has the US mobile industry buzzing.
Verizon and Microsoft have been linked for a number of years, recently signing a five-year agreement to make Live Search the default engine for Verizon phones.
However, reports indicate that Apple too is being courted by Verizon in an attempt to bring the iPhone over its network. The iPhone, which has sold more than 17m units worldwide, is offered exclusively through AT&T in the US. AT&T is presently seeking a one-year extension to the exclusive deal.
This could relate to Apple plans to introduce an "iPhone Lite" model on Verizon. In addition, Apple has what has been dubbed the "Mediapad" in the works. This is designed to take on Amazon's e-reader, the Kindle.
PDA manufacturer Palm has also been rumoured to be revealing its potential iPhone killer, the Palm Pre, next month before the annual Worldwide Developers Conference in June, where Apple is also expected to introduce a new iPhone during the keynote address.